Quantifying Risk Under the Watchful Eye of Government

The meltdown of America’s (and the world’s) financial sector has caused attention to be focused on the role of the credit rating agencies. It seems pretty clear that the system we are all familiar with is archaic and, to put it politely, less than reliable. As it happens, quantitative risk analysis is a science that has made great strides in recent years, but that progress was not reflected in the traditional credit ratings on which, with hindsight, far too much reliance was placed.

This analysis, by Kamakura Corporation, is self-interested but, I think, accurate. It contrasts the insights of modern risk analysis with the outmoded techniques of the rating agencies. I don’t think it’s available on the web, but you can read it by clicking on the pages below:

Some excerpts:

*Bear Stearns, rated A+ as recently as October 2007, was rescued in a Federal Reserve-assisted transaction by JPMorganChase on March 14, 2008.
*AAA-rated FNMA [Fannie Mae] was put into receivership on September 7, 2008.
*AAA-rated FHLMC [Freddy Mac] was put into receivership on September 7, 2008.
*Lehman Brothers declared bankruptcy on September 15, 2008, but it had been rated A+ in May 2008.
*AIG, which had been rated AAA as recently as 2005, was rescued by the U.S. government on September 16, 2008.
*Kaupthing Bank, rated AAA as recently as February 2007, was nationalized by the Icelandic government on October 9, 2008.
*Wachovia, rted AA- in June 2008, was “purchased” by Citigroup on September 29 in a distressed merger, only to sell later at a higher price to Wells Fargo.
*Citigroup, rated AA as recently as December 2007, was rescued by the U.S. government on November 23, 2008.

What is most troubling about this story is the role played by politics. Congress was not just an observer of the real estate/bank meltdown, it was an active participant that played a role which, with hindsight, we can all agree was both discreditable and corrupt:

Why were both rating agencies still rating FNMA and FHLMC AAA? National politics. A downgrade of the two “government sponsored enterprises” to BB (which the average behavior of the rating agencies would have dictated) might have–after the fact–been argued to be the “cause” of their failure, sure to be condemned by the CEOs of both firms and by senior government officials. This rating firms’ reluctance to downgrade FNMA’s and FHLMC’s debt is understandable–no business wants to be singled out for criticism by the government, even if they are correct in their credit assessment.

The failure of credit rating agencies to accurately assess the risk of default is an important aspect of the history of the current crisis. If this failure was the result of a reasonable fear of antagonizing a nearly all-powerful Congress, it is one more way in which misguided government policy and excessive government power created the perfect storm that we are now experiencing.